Marriage or Just Dating?

I exchanged a series of emails this week
with my friend and colleague Rich Toscano from Pacific Capital
Associates (an RIA firm in San Diego, CA) regarding the recent blood
bath in the commodity markets and the accompanying rally in the US
dollar. I've enjoyed years of collaborating with Rich and his partner,
John SImon, to try and navigate the crazy financial and economic times
we've endured. I've always found it critically important to engage smart
and serious people who are extremely good at what they do, as the
experience typically results in my learning things about how to become a
better investor. I came away from this week's email "conversation" with
Rich pondering something we are both grappling with - what investment
positions are we married to and which are we simply dating?

TEAM
has long been in the camp, as have Rich and John's firm, that commodity
markets are in a secular bull market, while the US stock market remains
in a secular bear market. This very basic concept is something that
shapes TEAM's entire investment process.

The problem with
marrying commodity investments is that the rough patches one must endure
during a commodities marriage look like WWIII compared to the arguments
I have with my wife. As an example, gold and silver mining stocks have
been in a tremendous bull market over the past 10 years, as the HUI Gold
Bugs Stock Index is up almost 15x's the level it was at 10 years ago.

In
the investment world, that is like being married to the most beautiful
person in the world who also happens to fit your personality perfectly -
true love indeed. However, such a marriage has not been all champagne
and roses! In fact, 2008 was enough to send even the best marriage into
intense marriage counseling, as the HUI crashed by over 70% from its mid
March 2008 peak to its low in mid October 2008...just six months later.

As
the chart directly above shows, living through that period of marriage
was a living hell, to which TEAM and our clients can attest. Fortunately
for us, we made the decision in March of 2008 that while we were still
married to the bull market in gold and silver miners, we needed to
dramatically reduce the amount of our position to which we were married
and consider the rest to be more like a summer romance....wonderful and
enjoyable while it lasted but destined to end. We made that move due to
our belief that a global deleveraging process could end up spilling over
into precious metals markets regardless of their long term
fundamentals. We certainly did not anticipate how profound the
deleveraging would be or that the collapse in the HUI would be over
70%!

By making this decision, we were able to keep our
portfolios largely intact despite the crash, and actual be able, and
even more importantly, willing to step in during the September-October
2008 period and engage in another summer romance by ramping our exposure
up once again.

Of course, categorizing positions as a summer
romance does not come without risks. "Trading" a bull market can be
difficult as one can mistime getting back into positions once they are
sold. It is this difficulty that sometimes makes me wish that all of us
at TEAM and also our clients could pull a Rip Van Winkle and sleep
through the remainder of the bull market so we could just reap the
rewards without having to suffer through the inevitable rough patches.

Present Day Marriage Counseling

We've
been locked in our bunker the past week considering what we own that we
are willing to move into the summer romance category. Our clients have
endured periods of decline like we are currently suffering relatively
infrequently in recent years, with May/June of 2006, January/February
2009 and May/June 2010 comprising the other three "drawdowns" of
significance. Not surprisingly, each of these periods included weak
stock markets, but more importantly the weakness in commodity markets
and related stocks was much more severe relative to the broader stock
market during those periods.

The epicenter of our poor
performance over the past few weeks has been the sharp correction in
precious metals mining stocks. The HUI index is down over 16% from its
peak in mid April to its low Friday. With that kind of decline, we are
left considering whether or not this is another run of the mill
correction, a deeper and scarier correction like May/June 2006, or
whether it is the beginning of another major decline like 2008. At this
point, we believe this will either be a run of the mill correction, or
at worst something similar to the 2006 period.

Portfolio Strategy

Much
of how we proceed from here will be contingent upon how market
volatility unfolds in the coming days/weeks. If the recent trend
persists, then we would likely arrive at the ultimate destination for
the correction relatively soon, though likely at levels significantly
lower than where they are currently. This would be the most negative
scenario for our strategy and client portfolios. Fortunately, at this
point we believe this is the least likely scenario, even though it is
not something we would characterize as unlikely. We believe it is more
likely that commodity markets and related stocks experience an oversold
rally of significance prior to suffering at least one more decline of
significance.

In this scenario, we anticipate reducing the
portion of client portfolios we end up labeling as "summer romances".
This would allow us the opportunity to buy that exposure back if there
is another phase of weakness before a deeper correction has
concluded. If a large short term rally develops, then we are likely to
reduce some commodity related holdings significantly. If the correction
enters into a meltdown mode, then we are likely to sit tight to a large
degree, despite that scenario being extremely uncomfortable in the near
term.

We certainly understand when clients become anxious
during periods like we are currently experiencing. We'd simply counsel
clients to try and remain focused on whether the long term foundational
reasons behind why we are married to the commodities bull market have
changed. We do not believe the major drivers, which are the continued
ascension of a middle class in emerging economies and the reckless
fiscal and monetary policies in the US, UK, Japan and much of Europe,
have changed at all. We will do our best to play the hand we are dealt
as this correction continues to unfold and remain diligent in looking
for signs that a more dramatic decline such as 2008 will emerge. While
we do not see indications that severe of a decline is probable, we will
not hestitate to act if/when our view changes.

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